Why Did Bank of America Pay Back the Money?

Everybody knows by now that Bank of America is buying back the $45 billion of preferred stock that the government currently owns. While the reason why they are doing this is obvious, I’m going to pretend it isn’t for a few paragraphs.
Buying back stock costs money — real cash money. Why would a company ever do such a thing? The textbook answer is that a company should do it if it doesn’t have investment opportunities that yield more than its cost of capital. The cash in its bank account, in some sense, belongs to its shareholders, who expect a certain return. If the bank can’t earn that return with the cash, it should return it to the shareholders. In this case, though, the interest rate on the preferred shares is only 5%, which is far lower than usual cost of equity. In fact, Bank of America just issued $19 billion of new stock in order to help buy back the government’s preferred stock. The cost of that new equity (in corporate finance terms) is certainly higher than 5%. In other words, Bank of America just threw money away.
In practice, companies buy back stock in order to increase their earnings per share. Fewer shares outstanding and the same earnings mean higher earnings per share and a higher stock price. In theory, this shouldn’t work: the benefit of having fewer shares should be exactly balanced by the fact that the company is now worth less (because it has, say, $45 billion less cash than it had yesterday). But in practice, it seems to work, probably because of signaling. But that doesn’t make sense in this case, either, since these are preferred shares that Bank of America is buying back, which have no claim on earnings. In effect, Bank of America is paying off cheap (5%) debt it doesn’t have to pay off — and to do that, it’s issuing new common shares, which will dilute existing shareholders.
Paying back its TARP money also has the effect of making Bank of America weaker. From a liquidity perspective, it now has about $20-25 billion ($45 billion minus $19 billion raised from new equity minus a few billion from other asset sales) less cash than it did before paying the money back. From a capital perspective, using cash to buy back preferred shares reduces your Tier 1 capital ratio. (I know there is disagreement about this, but the term sheet explicitly said that Treasury’s preferred shares counted as Tier 1 capital.)
So why?
The answer … which most of you know already … is to avoid executive compensation caps. From the Times article:
“It is a particularly delicate time for Bank of America, which has struggled to find a replacement for Mr. Lewis. By paying back the money that it received under the Troubled Asset Relief Program, or TARP, Bank of America will free itself from exceptional federal oversight of its executives’ pay — a thorny issue in recruiting a new chief executive.”
In retrospect, the executive compensation caps inserted by Congress into the stimulus bill back in February are having a perverse effect. Because the caps applied only to financial institutions that took TARP money — and they applied much more heavily to institutions that received “exceptional assistance,” like Citigroup and Bank of America — it tilted the paying field even more heavily against them. This gives them an incentive to take steps that weaken their financial condition, even as conditions in the real economy (to which Bank of America is highly exposed) remain bleak.
I support restrictions on the form of compensation in financial institutions, such as requiring them to be distributed in restricted stock that vests over several years (which is already standard practice at some banks, such as Goldman Sachs) and making bonuses in good years subject to clawbacks in bad years. But those restrictions have to apply to all financial institutions, not just some of them; otherwise, you get this situation where Bank of America is making a silly financial decision because it has to in order to hire a new CEO. (The fact that nobody will be CEO of America’s largest bank because of executive comp restrictions is another issue, but there’s not much we can do about that. I would do it, but I don’t want to move to Charlotte.)Update: Ted K. pointed out to me that Wells Fargo, which is generally considered less of a basket case than Bank of America, is not paying back its TARP money yet.By James Kwak

Related

By Vatalyst:
Preferred stocks are privileged stocks that are paid dividends before making any payments to the common shareholders. They carry components of both debt and equity, thus reducing overall investment risks. Preferred stocks are a good quality option for generating income return. Therefore, I have picked 8 stocks though offer competitive yields than fixed income products.
Bank of America Preferred Series 7 (BACPRD):

Submitted by Michael Shedlock via MishTalk.com,
Under guise of preventing fraud the ECB voted to kill the €500 note.
Fraud was not the real reason. The real reason was to make it more difficult for banks to store physical cash to avoid negative interest penalties... but it's not working.
Cash Under the Mattress

MUMBAI: Investors can expect a flurry of share buybacks in the months ahead from cash-rich companies looking to return some of that money to shareholders. This follows the February 29 Budget imposing a 10% tax on dividends of more than Rs 10 lakh per year. Wipro announced a buyback on Wednesday, the first company to have done so since April 1. Buybacks are another way of giving back cash to investors.

Submitted by Charles Hugh-Smith of OfTwoMinds blog, Those who actually create value as opposed to chasing yield with nearly-free money will actually have some traction once the swamp of excess liquidity drains.

Last night Fairholme Capital Management announced that it had a proposal for buying Fannie Mae and Freddie Mac's entire mortgage-backed security business, bringing in $52 billion in new private capital. This morning, the fund's CEO, Bruce Berkowtiz, was on CNBC explaining its plan.

By Investment Directions: Bank of America’s (BAC) situation is taking on the aspects of a Greek tragedy – or a farce. Despite Warren Buffett’s official statement that Bank of America is a well-run company, his way-too-small $5 billion in preferred stock with juicy terms is unfavorable to the bank.